Economics Beyond Markets
Transcript of Economics Beyond Markets
Maitreesh GhatakLondon School of Economics
November 27, 2020
Economics Beyond
Markets
Talk given to A-Level Students at University College School & its partner schools
• The narrow self-interest driven view of individuals in the
economic domain has increasingly come under question.
• Recent work in economics has moved beyond stylized
models of motivation based on a narrow view of homo
economicus who cares about only money and leisure,
and have embraced a wider perspective on motivation.
Introduction
Broadly speaking, this has been focused on different approaches
to pro-social motivation, such as:
commitment to a mission
the role of identity (being a "good" or "responsible" person, a good
teacher or doctor or friend or parent)
commitment to "in-group" (e.g., family, community, tribe)
intrinsic motivation
reputational concerns & social norms
status rewards
pure altruism.
Introduction
Relatedly, another trend is questioning the division of economic
activity between the markets and the government
The traditional belief that markets are the most efficient way
of producing private goods, while the government takes care of
public goods and services while also correcting a range of
market failures is no longer tenable
At the same time, the power of self-regulating markets to
achieve the greatest good for the largest number is increasingly
under question due to rising inequality and unemployment,
unravelling of social norms, democratic institutions, and
communities due to market forces, and environmental
degradation
Introduction
First, a large body of evidence on market failure where private
gains lead to social loss (e.g., bailout of banks during the
financial crisis) beyond what was already known (e.g.,
environmental pollution, lobbying by private corporations)
Second, a large body of evidence has accumulated on
government failure due, for example, to corruption, waste,
absenteeism, and poor quality of service.
Third, an increasing importance of private social-sector
organizations such as non-profits, NGOs, and social enterprises
as well as hybrid organizational forms such as public-private
partnerships, and contracting-out, make it too restrictive to
equate the provision of public goods and services with provision
through government agencies.
Several reasons
Historical PerspectiveThe Original Dilemma of Economists? The Two Adam Smiths
“It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.” The Wealth of Nations, 1776
“How selfish soever man may be supposed, there are evidently some principles in his nature, which interest him in the fortunes of others, and render their happiness necessary to him, though he derives nothing from it, except the pleasure of seeing it. Of this kind is pity or compassion, the emotion we feel for the misery of others, when we either see it, or are made to conceive it in a very lively manner.” The Theory of Moral Sentiments, 1759
Economists have adopted a simplifying strategy that goes back
at least to John Stuart Mill (1867)"[Political economy] does not
treat of the whole of man's nature . . . it is concerned with him
solely as a being who desires to possess wealth, . . . it predicts
only such . . . phenomena . . . as take place in consequence of
the pursuit of wealth. It makes entire abstraction of every other
human passion or motive."
Do Economists Really Believe in Homo
Economicus?
Is self-interest a good assumption?
If it simplifies things without leading you astray: yes
e.g. understanding the demand for usual goods and services
If it leads to wrong conclusions: no
e.g. charitable giving, volunteering
If we give up on self-interest, do we
have to give up on rationality?
Two separate concepts
Rational: consistently strives to achieve some goal
That goal can be entirely selfish or it can be altruistic
As long as it’s done consistently, it is rational
If Homo Economicus doesn’t exist why
make it up?
Economists use models
Good models are like maps: abstract from unnecessary
details to improve clarity
A map should provide enough detail to let us go from point
A to point B without either confusing us with unnecessary
details and without omitting important details.
Challenge is to understand which details are unnecessary
Example : London Tube map
Source: http://www.steveprentice.net/tube/TfLSillyMaps/
Too much detail!
Still too much detail!
Too little detail!
The London tube map that we use – just right!
Also, it depends on your purposeHave to walk? This one gives the physical distance!
So, how do economists reconcile self-
interested behavior in some domains and pro-
social behavior in others?
At the individual level?
At the level of organizations?
This strategy involves three separation assumptions
Separation between markets and the government (aggregate
level)
Separation between preferences and organizational
form/performance (organization level)
Separation between intrinsic and extrinsic motivation
(individual-level)
The Three Separation Assumptions of Economics
Markets are the most efficient way of producing private goods
but not for public goods (or mitigating public bads) where
appropriate tax/subsidy or direct provision by the government
is warranted
Also, tax and redistribution to tackle inequality & poverty
First and second welfare theorems: separation between
efficiency role of markets, and distributional concerns
Separation between markets and the government
Firms maximize profits independent of the preferences of the people
involved or competitive markets will push them out
Individuals maximize utility as investors, consumers or workers to
decide how much to sell, buy, where to work, invest etc
Production efficiency and preferences are separable
Business is business, and that does not mix with pleasure or ideals
No impact of preferences on the organization of production: purely
driven by technology, resources and forces of competition
Assumes there is a government sector and/or a charity sector that
takes care of everything else
Separation between preferences and organizational form
Individuals have preferences over various occupations, effort
levels (as workers), goods and services (as consumers),
investment opportunities (as investors)
For example, a worker may have a lower cost of effort when he
is working in a task he likes - intrinsic motivation
Money (wages, prices, returns) also affects the choice of
individuals to work, buy, or invest
These can be treated separately - if someone pays you to do
something you like to do anyway, then you do it even more
More formally, intrinsic and extrinsic motivation are substitutes
Separation between intrinsic and extrinsic motivation
Application – Economics of the Social Sector
The substantial presence of private nonprofits in the economy provides several conceptual challenges to economists.
According to the U.S. Bureau of Labor Statistics, in 2016, employment in nonprofit organizations represented 10.2 percent of total U.S. private sector employment.
In June 2019, the voluntary sector employed 909,088 people representing almost 3% of the total UK workforce.
Internationally, nongovernmental organizations (NGOs), a subset of organizations in the nonprofit sector that engage specifically in international development, have been supplementing and sometimes replacing government agencies in the provision of relief and welfare, social services, and various projects in developing countries.
The number of international NGOs rose from less than two hundred in 1909 to nearly one thousand in 1956 to more than twenty thousand in 2005 (Werkerand Ahmed 2008).
Economic Theories of the Social Sector
This substantial presence of nonprofits in the economy presents several conceptual challenges to economists.
First, if a private organization does not seek to maximize profits then what exactly is it, and how do we know that this supposed objective is not profit maximization by another name?
Second, how can an organization that does not maximize profits survive competition from for-profit organizations to the extent there are no entry barriers?
Third, how should we think about the grey zone in between the neat black and white separation of the economy into a profit-driven private sector that produces private goods efficiently, and a public sector that corrects market failure, provides public goods etc?
Trends within Economics
Increasing emphasis on pro-social motivation and how it interacts with incentives and selection
Particularly relevant in settings where
Outputs have significant social returns that are not largely captured in private returns, due to classical externalities or distributional concerns
Both outputs and inputs are difficult to measure that prevent a fully efficient solution due to agency problems.
Agents have some pro-social motivation - moving beyond the narrow view of economic agents as homo economicus, who are solely driven by private returns, such as, money and leisure and allow for a richer set of motivations (Benabou and Tirole, 2006; Bowles, 1998, 2016; Akerlof and Kranton, 2000, 2005, 2010; Besley and Ghatak, 2005, 2017).
Outside of economics, exploring the implications of pro-social motivation would need scant justification, but strong tradition of putting self-interest at the core of economic models
Social Enterprise
There has been a large literature on the economics of nonprofits since the early 1970s (e.g., Hansmann, 1987) that provide a convincing explanation of why the organizational form of nonprofits may be a constrained efficient solution to some underlying contracting problems
However, it does not provide an obvious framework to explain the rise of more hybrid forms of organizations in the social sector, often called social enterprise, which cannot be fitted into the simple partition of the economy into for-profits, non-profits and government organizations.
These are more flexible forms of organizations and combine features of both nonprofits and for-profits.
A Conceptual Framework
We start with the cost-quality trade-off as a canonical
model of contract failure that lies behind existing
theories of nonprofits
Discuss the rise of social enterprise and provide some
examples of these “dual-mission” organizations
Provide a theoretical framework where managers
with pro-social motivation can overcome the rigid
mission problem of both for-profits (objective is to
maximize profits) and nonprofits (do not maximize
profits)
Cost-quality trade-off
Suppose the quality of a service can be high or low,
namely, 𝑞 = 𝑞ℎ or 𝑞 = 𝑞𝑙 but it is not directly measurable
or observable to the consumer.
To produce higher quality, costs are higher to the firm
Suppose the costs of producing high and low quality are 𝑐ℎand 𝑐𝑙 respectively, with 𝑐ℎ > 𝑐𝑙.
As quality cannot be directly observed or measured, only
a single price can be charged for this service, which is
denoted by 𝑝.
Cost-quality trade-off
If this is a for-profit firm, then choosing low quality would
yield a profit of 𝑝− 𝑐𝑙 (which we denote by 𝜋) which is
higher than the profit if high quality is chosen instead,
namely, 𝑝− 𝑐ℎ (which we set to 0 for simplicity).
If this is a non-profit firm, then the manager or owner
does not directly benefit from the cost-savings that arise
from lower quality and will therefore have no incentive
not to provide higher quality.
This is a very simple illustration of a cost-quality trade-
off, which is an example of contract failure.
Mission Integrity Problem
Besley-Ghatak (2017) propose the mission integrity problem as a generalization of the multi-tasking problem that is behind the cost-quality trade-off
Suppose it is possible to verify the action of the manager, namely whether the pro-social or the commercial action was undertaken.
The problem is, suppose now there are two types of situations that can arise.
Sometimes social considerations indeed outweigh the financial consideration and so taking the pro-social action is the right thing to do.
However, in other situations, financial considerations may outweigh social considerations and there, the commercial action is the appropriate one.
𝜎 = 0 𝜎 = 1
𝑥 = 0 𝑆 = 𝑆, 𝜋 = 𝜋 𝑆 = 𝑆, 𝜋 = 𝜋
𝑥 = 1 𝑆 = 0, 𝜋 = 𝜋 𝑆 = 0, 𝜋 = 𝜋
Mission Integrity Problem
Note: 𝑥 is action, 𝜎 is state, 𝑆 is social payoff and 𝜋 is
profit. 0 is the “social” state/action and 1 is the
commercial state/action.
Mission Integrity Problem - Examples
Think of situations in which the goal is to widen access to
certain goods or services - education, health care, and
legal services are important examples.
The prosocial action can be interpreted as providing
access to “deserving” beneficiaries on preferential terms
(e.g., free treatment for the poor), while the commercial
action involves offering no special access or concessions.
The manager may observe an individual who is to be
served (say, a patient or a student or a potential
beneficiary of a targeted welfare program) and decide
what action to choose.
Mission Integrity Problem - Examples
The social objective may also be related to externalities associated with the good’s production.
For example, environmental externalities may arise requiring firms to balance cost efficiency against the social costs of pollution.
Suppose the commercial action is to use a standard technology, while the prosocial action is to use a costlier but more environmentally sound technology.
The manager’s choice is to decide whether it is worth giving up profits by choosing the latter technology if the environmental benefits that are external to the firm are substantial enough.
Mission Integrity Problem
The issue is, only the manager gets to observe the true situation and so by observing his or her actions we cannot figure out whether the right thing is being done.
One example of an institution that is designed to protect mission integrity with a rigid mission is a nonprofit firm – but then cannot take commercial action when that is more desirable
Similarly, for-profit firms maximize financial objectives & so do not take pro-social action when that is desirable
If social enterprises are able to recruit socially motivated managers they can overcome these problems – right action in the right state
Ironically, the non-profit clause is essential only if we assume self-interested agents – not with pro-social agents
Concluding remarks
Key insight – selection of agents has a direct bearing on organizational form (for/non-profit or social enterprise) and vice versa
Several important potential areas of research in this emerging literature that lies in the overlap of public economics and economics of organizations
Of particular interest in the financing of these organizations - for example, an additional advantage of social enterprises over nonprofits is that the former can raise equity but the latter is restricted to debt.
More generally, there appear to be several fascinating areas of future research relating to the continuum of organizations from commercial for-profits to social enterprises of various kinds to non-profits
The problem of mission drift and mission creep
Government regulatory policy regarding these organizations.